The old Chinese proverb goes, “the best time to plant a tree was 20 years ago. The next best time is today.” The same goes for saving toward your retirement.
When should you start saving for retirement? “As soon as possible” is sometimes the stock answer from financial advisors, but that is not practical for individuals embarking on this important and often ambitious task. We at TFC will guide you through the challenge and help you make the most of your various retirement accounts. Having a sound strategy and good habits is the name of the game.
You should start saving when you land that first 9-5 job after college. You accomplish that by taking advantage of your employer’s 401(k) matching feature. A 401(k) match is commonly offered at your place of work whereby you contribute 6% (for example) and the company pitches in an additional 3%, an instant 50% return on your money. Some companies even do a 100% match, but the percentages vary by company. Another good tip is to enroll in the ‘automatic escalation’ feature; an increase in your contribution rate at the turn of the year, usually when your annual raise hits. Why is this good? It helps you to increase your retirement savings rate without even thinking about it.
A few more details on the 401(k) account – it is done exclusively through your employer and typically uses pre-tax money. “Pre-tax” means you get a current year tax deduction. The money is then invested within the 401(k) account and grows tax-deferred. You will pay income tax on the withdrawals in retirement. Be careful though, if you withdraw money before age 59.5, you will face not only income taxes on the withdrawal but also a 10% early withdrawal penalty.
Maybe your job does not offer a 401(k) or perhaps you already contribute up to the 401(k) matching amount – what to do now? A Roth IRA can be the answer. The process is you contribute after-tax money from your checking or savings account into what is called a “Roth IRA”, named after a U.S. Senator. The Roth IRA is done on your own, not through your employer. What is great about a Roth IRA is that you can withdraw the money you contribute at any time, tax-free, penalty-free. The annual limit for the Roth IRA increases every few years with inflation. The 2020 limit is $6,000 for those under 50 and $7,000 for those 50 or older. So if you have contributed up to the match in your 401(k) account, look to max-out your Roth IRA.
Like the 401(k) automatic escalation feature, enrolling in ‘automatic-investing’ within in your Roth helps you ‘set it & forget it’. The more you can automate your retirement savings, the better!
Let’s review where we stand – if your salary is $50,000, and you contribute 6% of your earnings with a 3% employer match, that is $4,500 total. The Roth IRA cap is $6,000. So you are perhaps up to saving $10,500 per year for your retirement – that is absolutely fantastic if you are able to do it. Unfortunately, most Americans earning about $50,000 per year are nowhere near this lofty annual figure.
Here are some good rules of thumb for how much you should have saved for retirement by certain ages. By age 30, look to have saved an amount equal to your current salary. Then every 5 years until retirement, aim to have another amount equal to your salary saved. So by age 65, your retirement account balance would be about 9x your earnings. If your income at age 65 is $100,000, you would have about $900,000.
While your savings rate is perhaps the most important variable in building a nest-egg, investment returns matter too. If you contribute $4,500 per year, less than half of what was discussed earlier, then you may amass about $1,000,000 by age 65 thanks to compounding investment returns if you earn a 6.5% rate annually.
Let’s have some fun with the numbers – if you were a very good saver, and contributed the $10,500 amount each year, then earned 6.5% per year, the balance by age 65 would be more than $2.5 million! Of course, after inflation, that number would be about $1.5 million in today’s dollars. Albert Einstein called compounding returns “the 8th wonder of the world” for a reason!
Here is The Point + Action Items:
- Start saving for your retirement now. Use the employer 401(k) account, often accompanied by a matching feature. The money is deducted directly from your paycheck after you enroll. Also, look to sign-up for the auto-escalation feature.
- Contribute toward a Roth IRA – you do this on your own from your checking account. Setup the ‘automatic investing’ feature so money is taken from your checking account each month and deposited & invested into the Roth.
- Aim to have saved 1x your salary by age 30, then every 5 years have another year’s salary saved.
- You are not on your own! Sit down with TFC and let’s talk about your specific goals. We can develop the best strategy for you. Before you focus on retirement savings, it is ideal to create an overall financial plan first.